Achieving Balance

Freddie Mac has testified on numerous occasions over the past several years on the issue of GSE regulatory oversight and our basic position has not changed.

Our Position

We continue to support legislation that enhances the current GSE regulatory structure in a way that ensures continued public confidence in the financial viability of the housing GSEs, which remain two key pillars of our nation's housing industry and broader economy. That said, we have a responsibility to take into account the full impact of any proposed legislation on our continuing ability to fulfill our statutory mission of providing liquidity, stability and affordability to the nation's housing markets.

Over the years, the GSEs have proven to be highly adaptive, even elastic, but they are not infinitely so. This is because the GSEs, by design, were structured along three key dimensions that must be held in some sort of balance for the whole franchise to work. These three dimensions are mission, capital and shareholder return.

In the same way, legislation before us also needs to achieve this same type of balance. While there is a fair degree of "elasticity" in this balance, it is critical to note that there is a tipping point: GSEs are not infinitely elastic and cannot be all things to all people at the same time.

• A Balancing Act of Competing Policy Objectives
• Balance of Congressional Policy and Regulatory Discretion
• Balance Among Other Regulated Financial Institutions

A Balancing Act of Competing Policy Objectives

GSEs are highly adaptable institutions, having demonstrated considerable willingness and ability to adjust to changing policy emphases within the context of our statutory mission. Created in 1970, Freddie Mac spent a good part of our first 15 years focused on creating a vibrant secondary market for conventional conforming loans. We did this by introducing standardization and securitization to the mortgage market. In the late 1990s, we turned to the mortgage purchase side of the business and were the first to develop new automated tools to help lenders originate and sell mortgages into the secondary market with greater efficiency and lower costs. Homeowners were the chief beneficiaries of these innovative efforts, enjoying a fairer, faster and cheaper origination process. In 2001, the focus was on protecting subprime borrowers from certain predatory lending practices, and Freddie Mac took the lead by setting a number of consumer protections that have largely become industry norms. In 2004, we were directed to devote substantially more of our business to support affordable housing. On average, the 2008 goals are about two-thirds higher than the first permanent goals in 1996. Today, over 50 percent of our mortgage purchases and investments support mortgage financing for families with incomes below the area median or who live in underserved communities.

That brings us to the present. Witnesses testifying at a Senate Banking committee hearing in February 2007 urged the GSEs to voluntarily restrict investments in short-term hybrid ARMs. As announced on February 27, 2007, Freddie Mac once again took the lead and did just that. Beginning in September 2007, we will restrict our subprime purchases to those mortgages that have been underwritten to a fully-indexed level, with concomitant restrictions on the use of stated income and excessive debt-to-income ratios. We also are working to develop model subprime products, consistent with safety and soundness, which will provide safer financing alternatives for families with blemished credit.

Read more:
Freddie Mac Announces Tougher Subprime Lending Standards

Freddie Mac is pleased to be able to promote greater borrower protections in the subprime market. Unfortunately, at some point, such leadership actions may conflict with other policy and regulatory expectations of the company.

Perhaps the broader point – particularly in the context of new legislative and regulatory requirements that may be placed on the GSEs – is that while the GSEs have proven to be highly adaptive, even elastic, over the years, they are not infinitely so. This is because the GSEs, by design, were structured along three key dimensions that must be held in some sort of balance for the whole franchise to work. These three dimensions are mission, capital and shareholder return. While at certain times in our past, these objectives may not have been properly balanced, we are pleased to say that we've worked hard in the past three years to bring things back into a proper balance.

In the same way, the legislation before us also needs to achieve this same type of balance. While there is a fair degree of "elasticity" in this balance, it is critical to note that there is a tipping point: GSEs are not infinitely elastic. We cannot be all things to all people at the same time.

We believe we are approaching a time of difficult tradeoffs. Without a doubt, the GSE charters are valuable assets resulting in lower GSE borrowing costs. These savings are largely passed through to borrowers in the form of lower interest rates than can be obtained through the higher-cost jumbo market. Lower borrowing costs also provide the GSEs the ability to subsidize certain less profitable mortgage investments, as envisioned by our charters.

On the other hand, the GSE charters also come with a number of business restrictions and mission responsibilities. Unlike banks, to which the GSEs are so often compared, Freddie Mac's business is confined to the residential mortgage market – in good times and bad. We can't diminish our support for this market when there are more profitable investments to be had elsewhere.

Unfortunately, in the past few years, GSE reform legislation has become a tug of war over these two aspects of the GSE charters. One side of the debate appears to support provisions that would minimize the value of GSE charters in the name of reducing potential systemic risk and increasing competition for mortgage assets. The view is that the GSEs are too big, too risky and should be constrained in their ability to develop new products or innovate in ways that might affect the competitive landscape of the primary mortgage market. Proponents of this view support legislative provisions that would raise capital requirements, shrink the size and growth of our mortgage portfolio, and limit innovation through excessive regulation of virtually every aspect of our business.

At the same time, others want to take advantage of the value of the GSE charters by increasing the scope of GSE mission responsibilities and make them legally enforceable. These mission expansions would include the establishment of new financial obligations tied to our total mortgage portfolios; additional and greater targeting of the annual housing goals toward higher-risk borrowers; and the addition of explicit legal duties to serve underserved markets.

These two policy objectives – minimizing the value of the GSE charters while expanding GSE responsibilities cannot be achieved simultaneously. A few examples:

• Requiring capital above the actual risks of our business will slow growth and reduce dollars going to the new affordable housing fund.

• A greatly constrained retained portfolio will mean little or no ability to provide market support for mortgages when other investors leave the market. Conventional conforming mortgage rates likely will rise for consumers.

• Extremely aggressive housing goals that are targeted in very-low-income areas may result in unintended negative consequences. Excessive demand-side mandates can result in an over-extension of credit to some borrowers, with consequences like those we are seeing in the subprime market today.

• Restraints on growth and increased mission responsibilities combined with sustained excess capital will greatly reduce franchise value and diminish investment in GSEs.

Thus, the "awkward reality" – GSE regulatory reform is a delicate balancing act. Policymakers and regulators must solve a complex equation that strikes appropriate balances and tradeoffs.

Balance of Congressional Policy and Regulatory Discretion

A second balancing act that must be achieved in GSE reform legislation is the need to balance Congressional policy direction and regulatory discretion. Freddie Mac supports the intent and direction of H.R. 1427. However, we have concerns about how certain provisions in H.R. 1427 will be understood, interpreted and ultimately implemented. We are not talking about short-term concerns. GSE legislation has been many years in the making, and, if enacted, is unlikely to be revisited for years to come.

As currently drafted, the provisions dealing with issues such as capital, mortgage portfolios and business activity oversight are very broad. As an example, consider the proposed language on regulatory oversight of our mortgage portfolio. In contrast to portfolio provisions contained in the last year's Senate GSE bill (S. 190), H.R. 1427 does not specifically require or direct the regulator to reduce our mortgage portfolio. This has been widely interpreted as meaning that the regulator would not impose the drastic reductions in our portfolio called for by our critics.

However, the language does provide the regulator with very broad authority to limit or substantially reduce the size of GSE portfolios, if the regulator chooses to do so – making it possible to achieve the policy objectives of S. 190 through the provisions of H.R. 1427.⁴

The high-degree of discretion has cheered some GSE critics – and that worries us. A fellow with the American Enterprise Institute and long-time GSE critic recently noted that these requirements give the regulator the authority to substantially and permanently reduce the size of GSE portfolios. In a recent article, he wrote that "the language gives the director the necessary authority, if he chooses to use it" to force reductions in GSE portfolios, and thus H.R. 1427 "deserves the support of those who have sought this goal."⁵

Similar issues exist with regard to how a regulator might interpret other key provisions in the compromise legislation. For this reason, we believe it is essential that Congress provide greater clarity and direction regarding the continued role of the GSEs. Will the GSEs remain a vital force in the provision of low-cost mortgage money to America's homebuyers and renters? Or will the GSEs be pared back to serve an FHA-sized market? We think it is for Congress to decide.

Balance Among Other Regulated Financial Institutions

A final balancing act is the need to ensure that GSE regulatory reform is consistent with regulatory trends in financial services. While the regulatory pendulum during the past several years has swung toward increased regulation generally, in recent months there has been growing concern that it may have swung too far in financial services. From Treasury Secretary Paulson and a number of other key financial leaders, we have heard wise calls for "striking the right balance" in regulation – warning that "[e]xcessive regulation slows innovation, imposes needless costs on investors, and stifles competitiveness."⁶ A report jointly commissioned and issued by U.S. Senator Charles Schumer and New York Mayor Michael Bloomberg warns that overregulation is one of the principal factors endangering New York's position as the global financial center.⁷

Likewise, there is reluctance for the most part to substantially increase regulation in the financial services industry, even of lightly regulated sectors. For example, some policymakers and industry observers have called for greater regulation of hedge funds. The 1998 failure of a then little-known hedge fund, Long Term Capital Management, sparked a broader crisis in the financial markets that required the active intervention of the Federal Reserve System to address. However, just last month, financial regulators such as the President's Working Group on Financial Markets (which is comprised of the Secretary of the Treasury and the Chairmen of the Federal Reserve Board, the Securities and Exchange Commission and the Commodity Futures Trading Commission) indicated that instead of increasing direct regulation of hedge funds, their preferred approach is to focus on using existing regulatory structures to encourage improved transparency and market discipline among hedge funds and stronger risk management by counterparties and creditors.⁸

What is perhaps most striking about the public discussion over GSE regulatory oversight is how disconnected it is from this broader discussion of financial services regulation. None of the concerns being expressed about the dangers of overregulation are being applied to the GSEs – indeed, they are completely absent from the policy discussion. An outside observer might thus surmise that when it comes to regulation, the GSEs are infinitely elastic – no amount of regulation will materially impact their ability to function. This is just not the case. While Congress can impose any mandates or requirements it deems fit on us, it cannot compel anyone to invest in the GSEs, nor can it require anyone to do business with us. Like other companies, the GSEs must attract shareholder capital, and they must compete for the business of lenders. If we operate under legislative and regulatory restrictions that prevent us from providing shareholders a competitive return, we will not attract their capital. If we operate under restrictions that make it unattractive for lenders to do business with us, then they won't – they will go elsewhere. And then we will be unable to fulfill the purposes for which we were created – an outcome we believe no one in Congress wants.

But regulation must be rooted in the recognition that the GSEs are businesses that have to compete with other businesses in the marketplace. Capital is one key issue about which we ought to be particularly aware of competitive impacts. It is especially puzzling to contemplate a dramatic increase in required capital for the GSEs, at the same time as our main competitors are arguing that their capital requirements should be substantially eased under Basel II. In a recent study for the Mortgage Bankers Association, Professor Mark Flannery of the University of Florida found that even at current GSE capital levels, large banks under Basel II may be allowed to hold lower levels of equity capital against prime mortgage credit risk than the GSEs.⁹ If Professor Flannery is right, that will put a big squeeze on the GSEs' securitization business – the one area where there is the least controversy over the GSE role.

In addition, modern financial service regulators acknowledge the competitive impact of disparate capital requirements: one reason the bank and thrift regulators proposed Basel IA was to level the playing field for depositories not subject to Basel II’s substantial reductions in capital requirements for residential mortgages.

Furthermore, many of our competitors enjoy both explicit and implicit government guarantees. For example, banks' insured deposits total more than three-quarters of their loan portfolios, providing a low-cost and stable funding base because of government backing. In addition, beyond insured deposits, many large banks also benefit from the market's perception of implicit government guarantees. A recent Moody's report estimated there is a 98 percent probability that the government would bail out some of the nation's largest banks in the event of a crisis.¹⁰

Therefore, striking the right balance in regulation is just as important for us as it is for banks, insurance companies, broker/dealers, and hedge funds.

⁴The bill would direct the regulator to "establish standards by which the portfolio holdings, or rate of growth of the portfolio holdings, of the enterprises will be deemed to be consistent with the mission and the safe and sound operations of the enterprises." The regulator would be required to consider six specific criteria in establishing these standards, including "the potential risks posed by the nature of the portfolio holdings," as well as seventh which covers "any additional factors the Director determines to be appropriate...."

⁵Peter Wallison, "Viewpoint: House Bill To Authorize GSE Portfolio Lid," American Banker, January 12, 2007.

⁶Remarks by Treasury Secretary Henry M. Paulson on the Competitiveness of U.S. Capital Markets, Economic Club of New York (November 20, 2006).

⁷Sustaining New York and the US' Global Financial Services Leadership, January 22, 2007.

⁸See President's Working Group on Financial Markets, Principles and Guidelines on Private Pools of Capital, February 22, 2007.

⁹Mark J. Flannery, "Likely Effects of Basel II Capital Standards on Competition within the 1-4 Family Residential Mortgage Industry," manuscript, University of Florida, October, 2006.

¹⁰Moody's Announces Bank Rating Actions Resulting From Implementation of JDA Methodology – United States," March 2, 2007